Sponsored By:

2009: The Best Year Since 1935?

April 06, 2009

Dear Fellow Options Traders,

What a week and what a great start to the new month and new quarter. Stocks had their best four-week run since 1933.

If 2009 is the best year for the market since 1935, then options traders are going to have a great year. The CBOE Volatility Index (VIX) will eventually go lower, stock trading patterns will become more predictable and we're going to make a lot money.

But is this just another bounce or an inflection point?

Thursday marked a significant shift in flow. Large institutional derivative traders reported a huge increase in skew to the buy side with strong bids for consumer discretionary and early cyclical stocks. Whether or not this is a watershed moment remains to be seen, but this is a full-blown re-risking that we haven't seen since the bear bit.

1935, when viewed as a point in time, seemed pretty bad. The Great Depression had been raging for a few years and unemployment, which peaked in 1933 at 25% overall and 37% for non-farm workers, was still well above 20% in 1935. Life was so bad people did not even want to make babies. The number of births in the United States, which had been running at an annual rate of almost 3 million babies decades before and after 1935, plunged to 2.37 million in 1935.

But, when you look at 1935 as the start of time rather than a point in time, it might have been the best year ever.

If you were born in 1935, you found it much easier to get into great schools and obtain employment than prior generations because schools and employers were desperate to attract the few members of that birth year. By 1944, unemployment had dropped to 1.2% and trended around 5% through 1975. While there was some uncertainty and difficulty in the years ahead including World War II, Korea, Vietnam, the Cold War, terrorism, etc., but generally standards of living only improved. From 1935 forward, the stock market was essentially in a very long bull move.

As investors, we need to be focused on the present and the future. It is quite possible that 2009 is the 21st-century equivalent to 1935. By March 9, 2009, the stock market had lost 56% of its value after having only doubled in the prior five years. Prior to the 1929 crash, the market had risen sixfold. This has been a nasty sell-off. Unemployment now stands at 8.5% and is trending higher.

Even for the most-observant market analysts, it is very difficult to know what is happening in the big picture while it is actually happening. Economists decide we have entered a recession only many months after we have entered the recession. The point is that there are signs all around us that suggest that when we view 2009 as the start of time rather than a point in time, this is going to be one of the greatest years ever.

Sustainable Growth

Companies and consumers today are operating with much tighter fiscal controls. Although prudent spending restricts growth near-term, it makes whatever growth there is sustainable.

In San Francisco at the Web 2.0 Expo, entrepreneurs talked about how this may be the best time to start a company. They are working harder, adding more value, spending responsibly, charging reasonable prices and competing in a world with less competition. Rather than being funded by "funny" money including easy credit and excessive venture funds (venture capital fell 33% in Q4 '08 year-over-year), firms today are required to deliver products and services that satisfy true demand in a profitable manner and self fund.

A good allegory here is cholesterol, which has a good element and a bad element. So does leverage.

Bad leverage, at its worst, is using free debt to enhance equity returns. If you put no money down, 100% debt finance and the asset rises in value, you have theoretically made infinite profit. The problem with this bad leverage is if the asset goes down, it will kill you financially.

Good leverage is keeping your costs low so that every incremental dollar of revenue falls directly to the profit line. Across all of American industry, companies have lowered their bad leverage and raised their good leverage. Even with modest growth, profits will jump by a surprising amount.

Economic Evolution

What we have learned in the 100 years since Charles Darwin's birth is that evolution does not occur at a measured, gradual pace. It happens in fits and starts. Species can remain evolutionarily static for long periods of time until some cataclysmic event puts natural selection into overdrive.

Corporate America had grown fat and complacent over a period of many years on bad leverage both internally ingested and consumed by overzealous consumers. Just like a meteor hitting the Yucatan peninsula effectively terminating many dinosaur species, the credit crisis struck.

According to the Financial Times, 28,000 companies went bankrupt in 2007 while roughly 42,000 closed in 2008. Some of the companies that closed in 2008 were our biggest and represented the elimination of a huge amount of market capitalization. Going forward, the pace of business failures may increase, but it is unlikely that we destroy as much market capitalization.

In 2009, we should expect to see a continuation of the torrid pace of business failures. But what is coming on even faster are acquisitions.

Only the companies with the strongest balance sheets, lots of cash and corporate histories that are sufficiently robust to convince skittish lenders to lend are making acquisitions. The strong are surviving, evolving and becoming stronger and the weak are vanishing. This evolutionary jump will leave us with a market full of strong, capable companies that are poised to capture surprising profits on good leverage and reduced competition.

If we look forward, this does not seem so bad.

Back To the Present

As we said at the start of this weekly rant, 2009 may be the best year in the 21st century in the big picture on a look-forward basis, but there are always ripples. The VIX has yet to convincingly break down. It closed on Friday just under 40 but has yet to establish a clear downtrend.

A high VIX may be reflecting the consensus view that we are close to the end of just another bear market bounce. We are rapidly approaching earnings season (widely expected to be a train wreck) and U.S. retailers report same-store-sales on Thursday.

Overriding all of this, the Federal government continues to guzzle feel-good bad leverage at an astounding pace. The leaders of the G-20 nations agreed to triple the IMF's lending power to $750 billion and expand reserve currency by $250 billion last week. Government spending at all levels may seem even more incredible when tax revenues coming in this month surprise to the downside.

REVIEW OF OPEN POSITIONS

There are a lot of open trades at Options Trader. To provide you with a clearer view of what we are strongly recommending right now, we have added a section called "Top Trades Now" directly following our review of trade actions of the prior week.

We want to make sure you know what trades we are most excited about, given the latest market moves. The trades that are not included in "Top Trades Now" may continue to be attractive, but don't provide the same "hot" opportunities given their recent price action.

But first, let's review our most-recent actions.

Positions Closed

Grupo Televisa SA (TV) -- On Jan. 23, we recommended buying the TV April 15 Calls (TVDC) for $2 or less. We recommended closing this trade earlier today for a price of 75 cents or better.

Microsoft (MSFT) -- On March 17, we recommended buying the MSFT Oct 22 Calls (MSQJN) for 60 cents are better. We closed this trade over the course of two days last week for prices that returned more than 100% profit.

Research In Motion (RIMM) -- RIMM reported strong earnings last week that caused the June 25 puts we were short to drop to 10 cents. Given the margin requirements of most brokers and the fact we had captured 90% of the profit potential of this five-month trade in two months, we recommended you buy to close the position with a 90% profit.

Positions Opened

Host Hotels & Resorts (HST) -- On March 2, we recommended buying to open the July 5 Calls (HSTGA) for 90 cents or less. These options closed the week at $1.30 after a strong run in the stock. Let's wait and watch before adding to this position.

Bare Escentuals (BARE) -- On March 2, we recommended following the big money and "buying to open" the BARE June 5 Calls (URYFA) for 80 cents or less. These options closed the week at 85 cents.

TOP TRADES NOW

The open trades in this section are positions we would actively add new money based on Friday's closing prices. The full details of each trade are shown above and below and on the Options Trader Web site. We've updated some of the opening guidelines to take advantage of price fluctuations in our direction.

Alcatel-Lucent (ALU) -- On March 25, we recommended buying the ALU June 2.50 Calls (ALUFZ) for 15 cents or less. Although the stock ran up about 16% from March 25 through Friday, the calls can be bought for 20 cents. We strongly recommend taking advantage of this price pullback in ALU and adding to your positions.

Bare Escentuals (BARE) -- On March 2, we recommended following the big money and "buying to open" the BARE June 5 Calls (URYFA) for 80 cents or less. These options closed the week at 85 cents. BARE could really run on the slightest hint that the upticks in consumer spending we have seen during the prior two months will continue.

Patterson Companies Inc. (PDCO) -- Although the medical sector may not be the flashiest, it is relatively stable and growing. As of Friday's close, you have an opportunity to "buy to open" the PDCO July 20 Calls (DOUGD) for $1.35 or less. You can also attempt to establish this trade for the 5-cent credit by "selling to open" the PDCO July 17.50 Puts (DOUSW) for $1.40 or more. We like this trade as you get paid to wait to see if your July 20 call cashes in big.

Wright Medical Group (WMGI) -- On March 17, we recommended buying to open the WMGI Aug 15 Calls (QWMHC) for $1.25 or less and selling to open the WMGI Aug 12.50 Puts (QWMTV) for $1.90 or more to collect a credit of 65 cents. This gives us a winning shot if WMGI appreciates above $15 per share. The position continues to work and can be put on for a 25-cent credit today.

Citrix Systems (CTXS) -- On March 19, we recommended you buy to open the CTXS June 30 Calls (XSQFF) for 65 cents or better. For those interested in being paid to do this, we also recommended selling the June 20 Puts (XSQRD) for $1 or more to collect at least a 35-cent credit. CTXS has not traded below $20 per share during this recession. We continue to like this trade, and you can still put it on for a 10-cent credit. Institutional money flows continue to indicate the stock will hold up and the company may even be acquired.

GigiMedia (GIGM) -- On March 13, we recommended you buy the GIGM Oct 7.50 Calls (GBUJU) for 80 cents or better. Those calls closed on Friday at 80 cents. We still like this trade as it is a good company and a play on a potential new source of revenue to the Federal government.

Rackable Systems (RACK) -- RACK stock has stalled out in the past week. However, with $5.88 per share in cash and the RACK June 5 Calls (RQOFA) trading at 25 cents or less, we still think this is a good bet.

The remainder of our open trades are:

Schlumberger Ltd. (SLB) -- After several successful complete trades in SLB April 35 Puts (SLBPG) and SLB April 50 Calls (SLBDJ) our remaining position in SLB is a half short position in the puts. This position closed the week with a 90% gain. By April expiration, we expect the gain to be 100%.

Canadian Solar (CSIQ) -- We are long the July 5 Calls (GQAGA), which we opened for approximately $1.85. This is a volatile stock and even more volatile option. Profits can build and erode fast. Our current thinking is to let the trend be our friend as we have time to expiration. If big profits become available, we will move fast to capture them.

Yahoo! (YHOO) -- On March 12, we recommended you "sell to open" the YHOO April 11 Puts (YHQPK) for 32 cents or more, and "buy to open" the YHOO April 17 Calls (YHQDR) for 22 cents or less. The buying excitement surrounding MIcrosoft/Yahoo has died down. With April expiration on its way, we will be looking to close this trade profitably. Remember, we collected premium up front. If the trade expires worthless, that is not all bad as we have already made money.

Ivanhoe Mines Ltd. (IVN) -- On March 3, we recommended you buy shares of IVN for $4.45 and "sell to open" the June 5 Calls (IVNFA) for $1.20 or more, effectively making your entry price $3.25. IVN had a strong week and now the stock is close to $6 per share. We would not add to this position as effectively it is close to maximum theoretical profit potential.

Alcon Inc. (ACL) -- On March 4, we recommended you sell to open the ACL May 70 Puts (NOZQN) for $3.10 and buy the ACL May 105 Calls (ACLEA) for 45 cents. We sold 50% the calls on March 25 for $1.75. We are staying short the puts but would not add unless we saw a significant pullback in price.

Perrigo Co. (PRGO) -- On March 6, we recommended you "sell to open" the PRGO May 17.50 Puts (IQPQW) for $1 or more and "buy to open" the PRGO May 25 Calls (IQPEE) for 35 cents or less for a net credit of 65 cents or more. On March 26, we closed the call position for a 466% profit. We are staying short the puts but would not add money unless we saw a significant pull-back in price.

Novell Inc. (NOVL) -- On Jan. 19, we recommended using a spread order to simultaneously "buy to open" the NOVL Jan 5 Calls (WNNAA) for 50 cents or better and "sell to open" an equal number of the NOVL Jan 2.50 Puts (WNNMZ) for 25 cents or more, for a net debit of 25 cents. We continue to like this trade but would not add unless we saw a significant pullback in price.

Shaw Group (SGR) -- On Nov. 26 we recommended selling the April 12.50 Puts (SGRPV) for $2 or more. We covered half the position on Jan. 29 for 25 cents or better. Given the continued strength of the stock, we feel there is no rush to clear the entire position. This position last traded at 4 cents. Do not add new money to this trade, as it has already moved substantially in our favor.

Cadence Design Systems (CDNS) -- On Jan. 9, we recommended buying the CDNS May 5 Calls (CDNEA) for 60 cents or less. This position closed on Friday at 20 cents. We like this trade although the stock has not done much and the clock is ticking. We would not add new money to this position.

BE Aerospace (BEAV) -- The stock is above $9 and the company reiterated its earnings forecast of $2 per share for this year. In the past two weeks, we have suggested you add to this position and could even buy the April 10 Calls (BQVDB). The original trade is now breakeven, and we expect the stock should continue to climb higher as investors gain confidence in the company's earnings power. This is an April expiration and, as such, we would not add to this position.

PARTING SHOT

As we all know, the volatility in the market is high and option pricing is moving fast, and some of you have been asking about how to manage a trade when a recommendation moves away from our recommended limit price.

There have been several times when we pushed the send button to deliver the trade idea to you and prices immediately went against us. This is as frustrating for us as it is for you. We are doing all we can to deliver winning trades, and we want you to get in or out at winning prices.

Our general limit-price guideline is to allow yourself about 5 cents to 10 cents of flexibility. Remember, you can buy a partial position initially and then wait for more favorable pricing over the next few days. Prices often spike on the initial buying interest and then recede in the following days.

Alcatel-Lucent is an example where pricing jumped on the day of our recommendation from 15 cents to 25 cents without any meaningful stock movement. Over the next week, ALU appreciated about 16% while the option bid/ask pulled-back to 15 cents by 20 cents. Now is the time to start buying Alcatel-Lucent if you did not have a chance earlier.

If the stock takes off like a rabbit (like Bare Escentuals and Host Hotels & Resorts on Thursday and Friday of last week), don't chase it. In the worst case, we will miss this trade, suffer no loss except opportunity cost and be ready for the next one.

Have a great week trading.


Nick Atkeson and Andrew Houghton
Editors
Options Trader